Top of the Morning: CIO Strategy Snapshot - What comes next?
The desk views the recent developments in U.S. fiscal policy and credit ratings as indicative of potential volatility in the FX landscape, particularly with the U.S. dollar. Per the full note source, the downgrade by Moody's highlights the unsustainable trajectory of the national debt and rising interest costs, which could influence currency markets. The significant budget deficit currently exceeding $2 trillion poses risks to economic stability, likely impacting investor sentiment and forex flows. As traders assess these factors, the desk recommends monitoring USD trends closely amidst these fiscal challenges.
What the desk is arguing
The desk frames this as a critical moment for FX traders to reconsider U.S. dollar positions due to elevated fiscal risks. Jason Draho of UBS notes that the downgrade by Moody's signals a concerning fiscal trajectory for the U.S., which has ramifications for currency stability. The downgrade, driven by a national debt surpassing $35 trillion and rising interest service costs, underscores weaknesses that may complicate the dollar's strength.
Supporting this view, the U.S. federal government is currently running a budget deficit that exceeds $2 trillion annually, even as solid economic indicators like low unemployment persist. This contradiction may lead to increased selling pressure on the dollar as global investors reassess the U.S. fiscal policy landscape.
The alternative read would suggest that strong equity performance and positive market sentiment might counterbalance these risks, but the historical context of rising debt suggests otherwise.
Where it sits in our coverage
Our current consensus target for the USD reflects a cautious outlook at 1.075, with notable firm targets as follows:
This perspective aligns closely with BofA, which holds a more bearish outlook on the dollar, sitting at the lower bound of our consensus target range. However, the desk is situated toward the upper end of this spectrum, indicating a more bullish view amidst fiscal uncertainty.
How other firms see it
Firms like JPMorgan and Goldman Sachs appear to align on the necessity of vigilance in currency positioning, given the fiscal developments. In contrast, BofA argues for a significant depreciation of the USD based on anticipated fiscal strains.
Eyeball USD/CAD and EUR/USD pairs closely, as their trajectories could reflect the broader impacts of U.S. fiscal policies on cross-border trading dynamics.
03Traders should monitor USD closely amidst fiscal challenges
04Potential volatility in FX markets due to U.S. credit rating decline
Market implications
Watch for movements in USD/CAD and EUR/USD as they may reflect shifting investor sentiment prompted by U.S. fiscal policies. A critical level to note is 1.075 for the USD, as breaking through this could signal heightened volatility.
Risks to this view
If Congress implements aggressive fiscal reforms or if inflationary pressures force the Fed to adjust rates, it may bolster the dollar and invalidate this bearish outlook. Additionally, positive economic data could strengthen the case for USD resilience.
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Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. It was another positive week for U.S. equities following the news of a tariff truce between the U.S. and China.
However, the week did end with notable developments on the one big beautiful budget reconciliation bill and capped off by Moody's downgrade of its U.S. credit rating. So with that, joining me today on this Monday morning from our New York podcast studio to discuss those items and others, glad to welcome back Jason Draho, Head of Asset Allocation for the Americas with the UBS Chief Investment Office. Jason, welcome back from your travels.
Great to be back at the table with you and a lot to talk about. Good morning, Dan. Happy Monday.
It's good to be back. Yeah, it's a week off, but also it's been a few weeks since we've been able to do this in the studio together. Let's maybe begin with that Moody's downgrade of the U.S. credit rating, the U.S. losing now its last AAA credit rating.
What is your interpretation of this action by Moody's? Well, first, just why did Moody's do this? The answer they gave basically is that the continued growth in national debt and rising debt services costs amid still high interest rates puts the U.S. fiscal trajectory on questionable grounds or certainly at risk.
So that was their reason for the downgrade. This is not a surprise. They are the third rated agency to do this.
S&P did it back in 2011 and then Fitch did it in 2023. So it's really not necessarily kind of new news. It also doesn't really tell us or investors anything that we didn't already know regarding the U.S. fiscal situation.
The U.S. federal government is running a budget deficit of over $2 trillion a year. This is happening even with relatively solid growth and unemployment around like 4%, when typically you'd have much lower deficits, at least as a percent of GDP. And interest costs are taking up a large portion of federal tax revenue.
So I think it's been well known, documented, the U.S. fiscal path looks sort of on an unsustainable trajectory. This is not sort of new news that this downgrade. In terms of the market implications, we can already see it this morning, Monday morning, this is recorded at about 9.05, that a mini sort of sell America is kind of going on with the S&P 500 futures down about a percent.
Treasury yields are up anywhere from four to seven basis points across the treasury curve. The U.S. dollar is down almost a percent on a trade-rated basis. Gold is up about a dollar.
So it's consistent with what you kind of get. But I think after this sort of one-day move, this could end up being like sort of non-market moving news later in the week as the investors focus on other information. Again, not really new news.
It's also the case that a lot of investors who own securities, treasuries, in the past they might have been forced to liquidate and sell treasuries because their mandates would dictate you have to have a AAA rating, at least from one of the three rating agencies. But after Fitch, a lot of these investors changed those rules so they're not forced to sell. So there's not really any kind of questions about whether the U.S. is able to repay its debt.
I mean, we issue debt. We have our own currency. The overall private sector is in good financial health.
So the wealth piece there is not an issue. Just really, of course, the politics kind of involve more than anything else. And politically, credit downgrades have not really been a factor.
Politically it hasn't hurt either presidents or people in Congress. Again, this is why they tend to kind of ignore it. So it's notable.
It sort of tells us what we already kind of know about the U.S. fiscal situation. But from a market perspective, it's sort of a one day event and then the markets should move on. When you consider the timing of this development chase and this downgrade, it's quite interesting because as we've been following, congressional Republicans are trying to get a budget reconciliation bill passed by early summer, just a few weeks away at this point.
So what is the status of the progress on that bill? And will this downgrade have any impact on that? Well, I think Moody's or other agencies have spent a lot of time reviewing and analyzing.
They would put the rating on watch many, many months ago. So the timing of this on Friday afternoon, on the same day when this one big beautiful bill, that's literally the name right now, was in committee. There was a vote in the House Ways and Means Committee.
Five Republicans voted against it earlier in the day. This does not trigger Moody's decision at that point in time, it's just a nice maybe happy coincidence that it happened at that point in time. But it is sort of a reminder that as the downgrade, when we look at what this bill is being proposed, as you mentioned, there is a desire to move forward relatively aggressively.
After those five Republican House members voted against it in the committee, on Sunday the committee actually voted to move forward and now it's going to go to the House, likely for a vote this week. The reason the five Republicans were willing to flip their vote in committee is that they got agreement from Republican leaders to speed up cuts to Medicare. So they got some of the cuts that they were kind of looking for, at least enough to allow them to say they got some action.
Now beyond extending the expiring tax cuts that took effect back in 2018 under Trump 1.0, one thing about this bill that's being pushed forward is a lot of the additional cuts to taxes are sort of front load in the next few years versus spending cuts are spread out over time. So that's an important sort of dynamic we think about the fiscal impulse. The Committee for Responsible Fiscal Budget estimates that the House bill would boost the fiscal deficit in 2027 by nearly $600 billion or 1.8% of GDP.
Even for the next fiscal year of 2026, we could have a deficit that goes from 6.5% to 7%. So I think the one thing that is coming out of this is it's a little bit more fiscal expansionary than investors were assuming just a month ago. Not necessarily doing a lot to cut the deficit and we think about the actions earlier this year about DOGE, all the big cuts, that is barely a pebble in an ocean in terms of going ahead way on the fiscal front.
So just in timing, it goes to the House probably for a vote this week before the long weekend. The Senate is expected then to take it up in June. They may want to make their own changes, but I think what the House has done is try to proactively anticipate some of the demands from the Senate and build it in.
There could be then some further tweaks, but whatever is done then the House could go back and vote relatively quickly because there is certainly a desire among Republicans and there will be pressure from President Trump to get it done by early July. So I think on July 4th, that's the goal is to actually sign the bill. So things are progressing perhaps a little bit faster than investors expected and even the speed bump on the moon is downgraded to be like last all of two days.
Let's spend a few moments just talking about the markets, Jason. It was another positive week last week for US equities benefiting from the US-China deal to reduce tariffs. The S&P 500 now at this point is above its level from April 2nd known as Liberation Day.
So after this rally, this run up in equities, Jason, what do you expect from the markets from here? Well, it is quite a remarkable comeback for equities from the low back on, I guess it was April 6th or 7th, to kind of fully come back from being below 5,000 now to almost touching 6,000. If you look at a price chart of the S&P, it is like almost a V, a very sharp decline post Liberation Day and then it bounced back to even higher levels than it were right before it.
I would say that when we've seen this situation in the past where the markets kind of sell off very rapidly and then some data or policy changes and these things come back very quickly. This is not the exception. This is a norm of how I think financial markets kind of perform.
Granted, you needed those reprieves, the first and only reprieve on reciprocal tariffs and then of course the news with bringing down tariffs for U.S. and China to levels that are no longer almost exorbitant to the point where like now you have embargoes but now at least trade can ramp up. And the data that's coming out just in the past week in terms of shipping, it's been a rapid kind of comeback as different companies are booking shipping time, trying to get space now that they can kind of ship stuff in again, a window that may only be temporary. This is a 90-day reprieve where there's no guarantee this stays at these levels going forward.
But from a market's perspective, it's been also kind of a remarkable pivot from being fixated on the tariffs, the implications of tariffs, the slowdown, the consequence for earnings, potential recession, stagflation to by last week, the focus amongst investors had pivoted from tariffs as they've been, I'd say, quote-unquote, solved for the time being, at least temporarily in the minds of investors, to focusing on the fiscal situation. And this is not the Moody's, but this is the deal that was working through Congress. The fiscal implications, the deficit implications and what does it mean, I think that's what we saw a little bit last week.
You saw equities go higher but also rates go higher. It had elements of sort of a kind of mini reflation trade where everything kind of re-arises. Rates go higher, equities go higher, the U.S. dollar did not go higher, so that's not consistent with it.
So that was sort of how the market is now trading. It's much more on the fiscal, at least for the time being, as opposed to tariffs. And I think that will continue to be the focus this week as investors digest the news of what came out of the weekend.
I'm certainly seeing what's going to happen in the coming weeks as the bill does progress and is it actually going to be signed by July 4th. But as we kind of come back from the long weekend and move into June, the focus again will return to the economic data, looking for signs of impact in terms of growth, of inflation, a lot of discussion about price increases and we saw even over the weekend President Trump recommend to Walmart not to raise prices where they can, but this is sort of in the pipeline that is building. So investors will want to see the impact.
I think that the markets, certainly equity markets at the current levels have a forward multiple of back around 21. It is not cheap, it's pricing and relatively benign outcomes for trade. So it is a potential for kind of hiccups in the market.
I would say it would be the hiccups not because of any sort of downgrade from Moody's, but more along because that's not new news as I mentioned earlier. But it's been a kind of relatively positive run of Trump 2.0 economic policies from the nadir of back on April 2nd of giving the reprieve on tariffs, kind of walking that back, making some positive progress on the fiscal deal. So shifting from a very growth negative to some from that low to the deltas now to be incrementally kind of more growth positive from those concerns before.
So the markets have been pricing that, but now we actually have to see kind of follow through with the economic data and certainly trade deals. As we get into June and early July, the focus will be on what if we don't have deals, what does it mean for tariffs? Are they going to go higher or not?
It's the same thing with China. So I think positive developments, but I think the markets are going to reflect that now. I think a decent amount of good news both on fiscal and tariffs that may be a little bit presumptive at this point in time.
Yet still a lot of unknowns out there as we look ahead. Very much so. Yes.
So just to pick up on interest rates, Jason, for a few more moments, as you pointed out, they have been on the rise for the past month. How high could they go and what does that mean for the market outlook from here? Well, if you look at both the 10-year and the 30-year from kind of regional relative lows back in April, they're both up about 50 basis points.
With the 10-year now, as of this morning, just a little over 4.5%. The 30-year is breached the 5% level. Most of this rise, you could say, is pricing out those downside tail risks to growth as the tariffs have come down and the risk of trade wars escalating in ways that could make a recession likely.
Rates are kind of rising as the bid to safety, the flight to safety is kind of dialed back and now the growth outlook is improved. There is a little bit, I think also more recently, of some of the rise due to what's going on with the fiscal front, the size of the fiscal package, which is both incrementing more stimulus for the economy than investors assume, but also bigger deficits and so therefore more supply. So there's certainly an element where the fiscal situation has been lifting rates higher.
This morning, the move is probably a little bit more Moody's related than anything else, but we've been chopping around these levels now for about the past week. So the question is, what is the impact and how high could they go? At 10, you're at 4.5, I think the economy can do okay in that environment.
To go much higher to 4, 7, 5 or 5%, that starts to put pressure on the economy. So some would say that the solution for higher rates is higher rates, meaning they'll slow down the economy and then that will bring rates lower. There's overflexivity, so they're not really sustainable at that 5% level.
To go much higher from current yields, given what's already known by investors, you do need probably a surprise on the upside to growth data. So the expectations that growth will come down in light of the tariffs, if that's not materializing, if we're not seeing any weakness of the economic data as we move forward, the labor market, that could cause rates to go higher. Anything that would on the inflation front, at the same time growth doesn't go lower, but inflation does start to move higher.
So again, it's sort of a higher nominal growth environment, a little bit reflation. That could also delay Fed cuts. So back in April, around the depths of these concerns about recession and slowdown because of the tariffs, the market was pricing in almost 4 cuts as of December.
Now it's down to slightly under 2 as of this morning. So pricing at quite a bit of cuts. And if the inflation data is elevated and the economy isn't slow, well then you'll price out more cuts.
And there's been a pretty tight correlation between what market expectations are for where the Fed funds rate will be about a year ahead and where the tenure is. So if you just keep pushing out those rate cuts, the tenure can drip higher. So that is a potential risk.
Ultimately, we think the economy will get slower data. That will cause your rates to decline as we go into year end. But from a near term perspective, even though we're at kind of a high end of our range for the tenure at 4.5%, you can easily go higher in the near term, which is why when it comes to thinking about duration, not wanting to make a lot of duration calls at this point because rates could go lower.
You don't need to take a lot of that risk to get attractive yields and fixed income right now. So with that market outlook, Jason, in mind, as you mentioned earlier, still a lot of unknowns when it comes to U.S. trade policy, the road ahead for tariffs. Let's talk about asset allocation.
What kind of guidance can you share with our listeners, our clients, and what are your key messages at this time? Just think about like all disaster classes have had really big moves, whether it's equity selling off and then rallying, rates kind of selling off and then rising higher. Also the dollar sold off but actually bounced back a little bit.
Where we probably have right now is a bit of a consolidation phase to sort of digest all this information. I think investor positioning had been bullish and then got quite bearish and now it's kind of moving back to like a more of a neutral stance. And so I think the question is where do we kind of go from here?
A lot of good news has priced in. So investors will be in a bit of a wait and see mode to see what the data looks like, to see what happens with these trade deals, to make sure the progress is continuing there before the markets can push, the equity markets specifically can push a lot higher. There is certainly a risk, if you want to call it a risk, that the markets grind higher into the early part of the summer if the data doesn't sort of show signs of rolling over and deals and tariffs aren't being done and there's continuous sort of new tariff reprieve because investor positioning is still kind of biased towards adding risk exposure and that could sort of push the markets higher.
But at the same time, I think we could see things chop around for the time being, not only for equities but also for rates at these levels, for the dollar after kind of selling off, stabilizing a little bit again, sort of looking for the next kind of catalyst to make big moves. Which is why on the equity front a week ago, we downgraded equities from attractive to neutral after quite the significant run. This is not a negative outlook on equities, but just when you're up 16% in the matter four weeks, it's time to perhaps just take a bit of a pause before we see sort of another move higher.
Over the medium term, I'm thinking about 12 months, you do see kind of a good upside as earnings came in a little bit better than expected for Q1 and therefore the earnings outlook for this year relative to where we would have been a month ago, perhaps looking a little bit better. But we'll look for opportunities to kind of phase into exposure, any sort of pullbacks and equities would be an opportunity to add risk. Within equities, we like tech and the AI theme and what we saw is tech has performed quite well.
The AI theme is sort of back on track. So again, that's within equities. Fixed income, I already mentioned, duration is kind of don't need to talk a lot of duration risk for the time being, stay up in quality.
Just as we've seen equities rally back, credit spreads have tightened again very rapidly. So again, you don't need to take a lot of credit risk to or you're not getting paid to take a lot of credit risk to stay up in quality. The dollar has bounced back a little bit, but ultimately I think still structurally the dollar is going to sell off on a more longer term horizon.
The Moody's downgrade again sort of reinforces that the U.S. is on a fiscal trajectory that with large deficits, large trade deficits, that typically would mean a weak dollar over time and that we think that will continue to play out. And then gold was kind of taking a bit of a breather after a really strong rally this year. Some of that reflects the fact that as geopolitical risks, as trade risks come down, the need for hedges goes away.
But then again this morning, gold is up off this Moody's news. So the way we would think of it is as a portfolio diversifier, it's going to prove in its worth certainly in the past month and a half and today in the early price action is indicative of that. So from navigating the geopolitical, the political environment, the policy environment, gold continues to be I think a relatively attractive, more as a hedge at this point as opposed to seeing significant upside if the macro outlook is not going to be as bad as investors feared just a month ago.
Well, Jason, a lot going on across many fronts. So as always, a very helpful touch base to begin the trading week and appreciate the guidance as well when it comes to positioning and look forward to picking back up with our conversation again soon. Thank you.
You're welcome. Have a great week. You as well.
Thank you, Jason. Thank you for tuning in. Be sure to visit UBS.com slash studios to view the entire UBS studios suite of podcast channels along with our video offerings such as UBS Trending.
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